Private Equity’s Carried Interest Eyed by Congress: Taxes

Rep. Sander Levin, D-Mich., at a tv interview on the final full day of the 112th Congress, on Capitol Hill in Washington, Jan. 2, 2013. Levin, the top Democrat on the House Ways and Means Committee, said that "this is an issue of fairness." Photographer: J. Scott Applewhite/AP Photo

“It’s still alive,” said Andrea Whiteway, a partner at
Chicago-based McDermott Will & Emery LLP who works in
Washington. “Carried interest is still an issue that’s on the
table as far as possible revenue raisers, loophole closers.”

For private-equity managers, changes in the tax treatment
of so-called carried interest may affect them more than tax
increases now on the books. Congress faces a series of deadlines
in the next few months over spending cuts, the debt ceiling and
the annual budget. Democrats including President Barack Obama
want to raise more revenue, and carried interest is an obvious
candidate.

“There continues to be no rationale whatsoever for people
to pay at a vastly lower tax rate when they are managing other
people’s money,” Representative Sander Levin of Michigan, the
top Democrat on the House Ways and Means Committee, said in an
e-mail. “This is an issue of fairness that we should address as
we seek a balanced approach to deficit reduction that involves
both additional revenues and spending cuts.”

The share of profits in buyout deals, known as carried
interest, is often taxed as capital gains, which receive
preferential rates under the tax code compared with levies on
wages. In the budget deal, lawmakers increased the top rate on
long-term capital gains to 20 percent from 15 percent and the
maximum rate on ordinary income to 39.6 percent from 35 percent.

Rate Differential

The big rate differential between capital gains and
ordinary income makes it likely that carried interest could lose
its tax treatment, said Whiteway, who heads the practice dealing
with partnerships for the McDermott law firm.

Democrats including Levin have sought to tax carried
interest as wages for more than five years, saying private-equity managers’ compensation should be treated like workers’
salaries. Obama’s most recent budget plan called for this
change, which would raise about $16.8 billion over 10 years,
according to the Joint Committee on Taxation.

The president repeated his desire to limit tax breaks in in
his weekly address on Jan. 5. In a Jan. 6 interview on CBS
Corp.’s “Face the Nation,” House Minority Leader Nancy Pelosi,
a California Democrat, identified carried interest as a tax
break that should be reviewed in coming negotiations over the
budget deficit.

Republican Resistance

Democrats face resistance from Republicans as lawmakers
gear up for a fight next month over the U.S. debt. Senate
Minority Leader Mitch McConnell, a Kentucky Republican, said
Jan. 6 on ABC’s “This Week” program that further tax changes
are off the table.

The private-equity industry and other investors will incur
an increase in taxes paid on capital gains as a part of the
recent budget deal, Steve Judge, president and chief executive
officer of the Washington-based Private Equity Growth Capital
Council, said in an e-mail. The group represents about 35
private-equity firms including Blackstone Group LP and Carlyle
Group LP.

“Carried interest is appropriately taxed as a capital gain
and is commonplace in venture capital, real estate and private
equity partnerships,” Judge said. “Given the industry’s recent
contribution to deficit reduction, it is our hope that any tax
reform effort in 2013 will be about crafting policies that
incentivize economic growth.”

Budget Deal

The Jan. 1 budget deal that averted most of the $600
billion in tax increases and spending cuts scheduled to take
effect this month -- known as the fiscal cliff -- raised the top
rate on capital gains to 20 percent. The 2010 health-care law
tacks an additional 3.8 percent surtax on investment income of
high earners starting this year, bringing the maximum rate to
23.8 percent from 15 percent. That’s a 59 percent increase.

For private-equity managers, a change to the treatment of
carried interest could have a much bigger effect, said Hunter
Payne, partner and general counsel at McLean, Virginia-based
Harbour Capital Advisors LLC.

If carried interest were taxed as ordinary income, the top
rate on such profits would increase to 39.6 percent. High
earners also face a 0.9 percent added tax on wages starting this
year as a result of the health-care law. That means the top rate
would be 40.5 percent compared to 23.8 for capital gains, or a
70 percent rise.

“The magnitude of that potential increase is much
higher,” said Payne, whose firm advises high-net-worth
individuals, including private-equity managers. Many private-equity managers receive the bulk of their income through carried
interest, he said.

Presidential Campaign

Carried interest may be an easy target if lawmakers in
coming months go after tax breaks in the code, Payne said. “The
general public may not have a lot of sympathy for it,” he said.

The 2012 presidential campaign focused attention on the
taxation of private-equity managers because Republican nominee
Mitt Romney, the former chief executive officer of Bain Capital
LLC, built his wealth in the industry. Romney’s 2011 tax return
showed he paid a 14.1 percent federal tax rate on $13.7 million
of income because much of his income was taxed at preferential
rates.

Congressional Scrutiny

Heads of private-equity firms including David Rubenstein,
who co-founded Carlyle Group, indicated in November that they
expect carried interest to be among the tax breaks that the new
Congress will scrutinize.

“Carried-interest taxation and a great variety of other
issues will no doubt be addressed,” Rubenstein said Nov. 8.

Billionaire George Roberts, who runs the private-equity
firm KKR & Co. with his cousin Henry Kravis, said on Nov. 14
that “it would be good to look at everything in the tax code”
to make it simpler and fairer. Roberts has an estimated net
worth of $4.4 billion, according to the Bloomberg Billionaires
Index.

Still, the tax treatment of carried interest may not be
changed because the budget deal didn’t include an overhaul of
deductions or expenses in the tax code, said Libby Cantrill, who
focuses on public policy issues for the asset management firm
Pacific Investment Management Co. based in Newport Beach,
California.

‘Less Likely’

“We think tax reform is much less likely now than it was
in the fall of 2012,” Cantrill said. “As a result, it’s likely
we’ll see things like carried interest preserved.”

If tax law changes are made affecting carried interest,
private-equity managers may have incentive to sell appreciated
investments or restructure partnerships before new rules would
take effect, Whiteway of McDermott said.

Last year, some private-equity managers moved to take
advantage of the preferential rate on capital gains including
carried interest. They refinanced investments, accelerated gains
on deals and shifted what they transferred to trusts.

People who receive carried interest are still bracing for
changes, said Jim Brown, partner in the tax group at Willkie
Farr & Gallagher LLP in New York.

“They fear that it is on the table and they’re hopeful
that it won’t come to pass,” said Brown, who specializes in the
interests of investors and funds. “I would expect it would be
part of the negotiations of any tax reform effort.”